LOS b: Explain the advantages of using credit derivatives over other credit instruments.

Q1. Which of the following is least accurate regarding credit default swaps?

A)   The credit default swap market is highly regulated by government authorities.

B)   Liquidity is usually greater in the credit default swap market than in the underlying cash market.

C)   Short positions are more easily obtained using credit default swaps than shorting a bond.

Q2. An investor would like to discreetly take a long position in a firm’s debt. Which of the following would be the most appropriate strategy?

A)   The sale of a credit default swap.

B)   The purchase of a bond.

C)   The purchase of a credit default swap.

Q3. An investor believes that a bond may temporarily increase in credit risk. Which of the following would be the most liquid method of exploiting this?

A)   The sale of a credit default swap.

B)   The purchase of a credit default swap.

C)   The short sale of the bond.

LOS b: Explain the advantages of using credit derivatives over other credit instruments. fficeffice" />

Q1. Which of the following is least accurate regarding credit default swaps?

A)   The credit default swap market is highly regulated by government authorities.

B)   Liquidity is usually greater in the credit default swap market than in the underlying cash market.

C)   Short positions are more easily obtained using credit default swaps than shorting a bond.

Correct answer is A)

Credit default swaps are not highly regulated because they are confidential, over-the-counter contracts. Liquidity is often greater in the credit derivative market than it is in the underlying cash market.

Q2. An investor would like to discreetly take a long position in a firm’s debt. Which of the following would be the most appropriate strategy?

A)   The sale of a credit default swap.

B)   The purchase of a bond.

C)   The purchase of a credit default swap.

Correct answer is A)

If an investor believes the firm’s credit prospects are good and wishes to discreetly capitalize on this by taking a long position, the investor should sell a credit default swap. Credit derivatives are confidential, over-the-counter contracts. By selling the swap, the investor would receive a premium up front and owe no further compensation to the swap buyer if in fact the debt does not experience credit risk.

Q3. An investor believes that a bond may temporarily increase in credit risk. Which of the following would be the most liquid method of exploiting this?

A)   The sale of a credit default swap.

B)   The purchase of a credit default swap.

C)   The short sale of the bond.

Correct answer is B)

If an investor believes the firm’s credit prospects are poor in the near term and wishes to capitalize on this, the investor should buy a credit default swap. Although a short sale of a bond could accomplish the same objective, liquidity is often greater in the swap market than it is in the underlying cash market. The investor could pick a swap with a maturity similar to the expected time horizon of the credit risk. By buying the swap, the investor would receive compensation if the bond experiences an increase in credit risk.

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